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International Finance FINA 5331 Lecture 3: Balance of Payments History of Monetary Institutions Read: Chapters 2 & 3 Aaron Smallwood Ph.D. Review: Triangular Arbitrage Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists. ¥ Tokyo Budapest S($/¥)=.01002-08 $ S(¥/€)=126.8145127.2045 Madrid S($/€)=1.29670-75 € Review: Triangular Arbitrage Sell $10,000,000 for ¥ at S($/ ¥) ask = ¥ 0.01008 receive ¥992,063,492.06 Sell our ¥992,063,492.06 for € at S(¥/ €) = ¥127.2045 receive €7,798,965.38 Sell € 7,798,965.38 for $ at S($/€) =1.29670 receive $10,112,918.41 profit per round trip = $ 10,112.918.41- $10,000,000 = $112,918.41 Balance of payments • Current account – Merchandise trade: trade in tangible goods – Services: trade in services, including tourism and insurance premiums – Unilateral transfers: gifts – Investment income: return on a previous investment • Positive entries (credits) are those that bring foreign currency into a country or are entries we think of as exports. Balance of payments • Financial account – Includes portfolio investment: Sales of purchases of financial assets – Foreign direct investment: Implies investment where ownership is made by a foreign party – Other investment: Transactions in currency, bank deposits, and so on. • Positive entries (credits) increase liabilities or decrease assets Official reserves • In the US official reserve assets include gold, foreign currency, and special drawing rights (issued by the IMF). • The official settlements balance is BCA+BFA • When BCA+BFA≠0, the central bank must acquire or deplete holdings of official reserves. Examples • Example 3.1: Boeing (US) exports a 747 to Japan Airlines for $50 million. Japan Airlines pays from its dollar account at Chase. • Example 3.3: Ford acquires Jaguar, a British car manufacturer for $750 million paid from deposits at Barclay’s. • Example: In an intervention move, the Federal Reserve sells RMB10,000,000 in the open market. The RMB are used by a trader to purchase manufactured goods from China. International Monetary Arrangements • International Monetary Arrangements in Theory and Practice – The International Gold Standard, 1879-1913 – Bretton Woods Agreement, 1945 – The Fixed-Rate Dollar Standard, 1950-1970 – The Floating-Rate Dollar Standard, 19731984 – The Plaza-Louvre Intervention Accords and the Floating-Rate Dollar Standard, 1985-1999 Additionally • What exchange rate systems exist today? – The choice between a fixed system and a flexible system. • How does another country’s exchange rate system affect you? How does China’s changing exchange rate system affect you? • What are currency crises and how can they impact your business? • What is the euro? Will the euro-zone expand? How does expansion of the euro-zone affect you? The International Gold Standard, 1879-1913 Fix an official gold price or “mint parity” and allow free convertibility between domestic money and gold at that price. • Countries unilaterally elected to follow the rules of the gold standard system, which lasted until the outbreak of World War I in 1914, when European governments ceased to allow their currencies to be convertible either into gold or other currencies. The International Gold Standard, 1879-1913 For example, during the gold standard, the dollar is pegged to gold at : U.S.$20.67 = 1 ounce of gold The British pound is pegged at : £4.2474 = 1 ounce of gold. The exchange rate is determined by the relative gold contents: $20.67 = £4.2474 $4.866 = £1 The International Gold Standard, 1879-1913 • Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. • Misalignment of exchange rates and international imbalances of payment were automatically corrected by the pricespecie-flow mechanism. Price-Specie-Flow Mechanism • Suppose Great Britain exported more to France than France imported from Great Britain. • This cannot persist under a gold standard. – Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. – This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain. • The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France. The International Gold Standard, 1879-1913 • With stable exchange rates and a common monetary policy, prices of tradable commodities were much equalized across countries. • Real rates of interest also tended toward equality across a broad range of countries. • On the other hand, the workings of the internal economy were subservient to balance in the external economy. The International Gold Standard, 1879-1913 • There are shortcomings: – The supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves. – Even if the world returned to a gold standard, any national government could abandon the standard. The Relationship Between Money and Growth • Money is needed to facilitate economic transactions. • MV=PY →The equation of exchange. • Assuming velocity (V) is relatively stable, the quantity of money (M) determines the level of spending (PY) in the economy. • If sufficient money is not available, say because gold supplies are fixed, it may restrain the level of economic transactions. • If income (Y) grows but money (M) is constant, either velocity (V) must increase or prices (P) must fall. If the latter occurs it creates a deflationary trap. • Deflationary episodes were common in the U.S. during the Gold Standard. Interwar Period: 1918-1941 • Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market. • Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game”. • The result for international trade and investment was profoundly detrimental. • Smoot-Hawley tariffs • Great Depression Economic Performance and Degree of Exchange Rate Depreciation During the Great Depression